Decoding RBI’s policy on foreign debt

The RBI’s two-pronged strategy to protect the economy from tapering-led volatility discourages unproductive external borrowings and prods foreign portfolio debt investors to think long-term. There’s another vexed issue: the IMF has sounded a cautionary note on the rising number of foreign currency debt laden Indian firms

The Reserve Bank of India (RBI) recently issued a curious circular to all banks in India. It barred Indian banks with overseas operations from lending foreign currency to Indian companies, or from giving them guarantees that help them raise loans from other overseas banks, so that the loan proceeds can then be used to repay outstanding rupee loans in India. [1]

What is intriguing about this notification is that it revokes a 2012 decision that allowed Indian companies to raise money overseas to repay rupee loans. [2] But, when viewed in conjunction with a few other recent policy measures, a clearer picture emerges of the RBI’s attempts to fashion an external policy, especially one that attempts to limit the Indian economy’s vulnerability to external volatility that may arise as a result of U.S. Federal Reserve’s tapering policy.

There is, of course, the RBI’s obvious concern about the rising swell of non-performing assets (NPAs) on bank books. NPAs pose an impending risk to the Indian banking system and the economy which, if left unresolved, could damage the credit markets for a very long time. In January 2014, the RBI even released a framework for revitalising distressed assets. [3]

Even the International Monetary Fund (IMF), in its latest instalment of the Asia Pacific Economic Outlook [4], has struck a cautionary note about the high proportion of corporate NPAs, which it feels is a threat to economic stability. According to the IMF’s outlook, a third of India’s corporate debt belongs to highly leveraged companies – with a leverage of three times or more (for every Rs. 100 of share capital, these companies borrowed Rs. 300 or more), the highest in the region. Unfortunately, many of these companies also have a low profit to interest payments ratio or the interest coverage ratio (ICR); this means they have little profits left, after taking care of operating costs, to pay interests and taxes.

The IMF report further says that for companies with external borrowings, any currency depreciation is likely to adversely impact the ICR. This is probably what is giving the RBI anxious moments. There are clearly two strands to the external strategy that the RBI is trying to construct.

At a broader, macro level is India’s total external debt position, which amounted to $425.970 billion on December 2013, a jump of 13.2% from $376.292 billion on December 2012 [5, 6]. India’s external debt has been rising – especially since the Indian central bank started raising benchmark interest rates to counter deeply embedded inflationary trends. This prompted many Indian companies to tap cheaper external markets for loans.

Commercial borrowings currently total $134.229 billion, according to data of the Ministry of Finance – a jump of over 90% since December 2009. It was after January 2010 that the RBI increased interest rates 13 times in 18 months. Even non-resident Indian (NRI) deposits have spectacularly risen, especially after the RBI aggressively campaigned for them – starting in September 2013 – to counter the steep depreciation of the Indian rupee. NRI deposits amounted to $98.639 billion on December 2013, a clear increase of 107.7% over the $47.490 billion in December 2009. These deposits have to be repaid over the next two to three years.

The rising external debt number is bound to induce a sense of foreboding when viewed through the prism of critical macro ratios: the RBI’s total hoard of foreign exchange reserves can now service only 69% of the external debt, compared to 138% in 2007-08 .The total outstanding is 23.3% of GDP; it has always been lower than this since 1998-99. And concessional debt comprises only 10.6% of total debt stock, which means a higher debt servicing burden.

Clearly, one of the objectives of the circular – apart from avoiding the cosmetic transfer of risk from the domestic balance-sheet – is to keep a lid on external debt, especially since tapering by the U.S. Fed is likely to keep the external economy volatile. Allowing Indian companies to now raise funds overseas to repay domestic debt might aggravate the situation.

The second purpose of the circular is to address the probable risks that might arise from short term external debt, or loans that have to be repaid within 12 months. Short-term debt is 21.8% of the total debt now, and is lower both as a percentage of total outstanding external debt as well as in absolute numbers compared to the immediate preceding months.

India’s stock of short-term external debt – Ministry of Finance data shows – touched $92.707 billion at the end of December 2013, or close to 21.8% of the total debt, compared to $91.881 billion in December 2012, comprising 24.4% of total external debt then.

What can be worrying the RBI is the money streaming into short-term debt instruments – such as the 91-day treasury bills issued by the government or the commercial paper floated by companies – since January 2014, figures for which are still not available. This rush of investment has been facilitated both by the interest rate differential between western markets and India, as well as the stronger rupee vis-a-vis the dollar.

One of the clear indicators to RBI’s strategy was revealed in RBI Governor Raghuram Rajan’s first bi-monthly policy statement of 1 April 2014. The RBI announced that henceforth foreign portfolio investors will not be allowed to invest in any government security, including treasury bills, with residual maturity of less than a year. [7] While the ceiling for investments in government securities remains fixed at $30 billion, the RBI wants it invested entirely in government paper with maturity of more than a year. This, the RBI hopes, will deter the yield-chasing, short-term investors and insulate the economy from volatility.

To soften the blow, the RBI has handed out portfolio investors a number of sweeteners that facilitate the process, and lower the cost, of investing in Indian capital markets. One, portfolio investors can now open a local bank account and directly transfer the capital they can invest into that account, unlike the earlier tedium of having to route funds through a custodian bank, which added considerably to the time lag between intent and investment. [8]

Portfolio investors can now also hedge their currency risks in the local exchanges, provided their investments are in government debt of more than 12 months in maturity. [9] This is bound to lower their costs, apart from giving them further inducement to invest in Indian paper.

The RBI’s moves clearly show its determination to keep a leash on short-term external debt. One of the reasons, according to India Ratings, can be a rush for the exit by short-term lenders during the tumultuous and volatile period for the rupee between May and August 2013. [10] But, at the same time, the RBI has also demonstrated that it does not want to give up on foreign portfolio investors yet, especially given the enduring nature of the Indian economy’s current account deficit.